Volatility, Fundamental Analysis, and the Bear Market of 2018

The week of March 20 – 24 2018 was the worst week for the American stock market in over two years. Both the Dow and the S&P declined over 5% in a week, entering correction territory, and concerns are mounting over the viability of Big Tech being weighted so heavily in various market indexes. Stocks are now slated to end the quarter in negative territory, and bond yields continue to steadily rise. With corporate tax cuts largely priced in, prospects for US-based companies to remain profitable and organically growing seem to be diminishing in the face of an ever more protectionist world. How, then, are retail investors like you and me supposed to make any money?

In this blog post, I will endeavor to explain the investing climate of 2017 and 2018 so far, with emphasis on events that have caused the recent spikes of volatility, as well as talk about my own investment strategy. I will mention various macroeconomic factors leading to the current climate, but as this is a financial markets oriented post, I will focus on how the markets look.

After the 2016 election, capital markets around the world became obsessed with the concept of Reflation, the idea that animal spirits would lead inflation to soaring new heights and the US and world economies would suddenly and magically revitalize and boom. During the ensuing months, both stock prices and bond yields rose rapidly, while the US Dollar strengthened against other major currencies. The British Pound slumped due to Brexit, the Euro took a hit when other elections were held, and the Yen continued to be a global safe haven but was weighted down by fears of a nuclear North Korea. But perhaps the most telling of this trend was in the VIX.

The VIX, or Volatility Index, is a measurement of how much implied risk there is in the stock market. It is comprised of a series of call- and put-options of varying lengths bought and sold on the S&P 500, and the actual VIX number is a measurement of the spread between those option prices. Traders will buy and sell call options if they believe the underlying security will go up, and will buy put options if they believe the underlying will go down. A higher number for the VIX means the price of a call and a put is wider apart, making there more ‘implied risk’ in the market, while a lower number means those options spreads are tighter, and less risky. For context, the VIX typically spikes during times of volatility and settles for longer periods of time when there is not as much.

What is telling about the 2017 stock market rally is that the VIX hit levels not seen since before the turn of the millennium. Not on the high side, which would indicate higher volatility, but on the lower side. Throughout almost all of 2017, the VIX declined from 14.04 to 9.22. For historical context, in 2008, the VIX peaked at 41. Volatility levels this low suggest that not only were spreads between buys and sells in the market extremely tight, but also explained why there were so few days of 2017 with more than a 1% move up or down. Investors seemed so sure that tax cuts and deregulation would spur the market to go even higher that they were actively making it play out that way. And it certainly showed; The S&P 500 index, as measured by the security ticker SPY, rose from $223.53 on 12/29/2016 to $266.86 on 12/29/2017, a 19.4% upward move. By many metrics, 2017 was a seller’s market.

2018, however, has not panned out the same way, and what was sunshine and roses last year may have started to show its vicious underbelly this year. NAFTA renegotiation talks have gone nowhere, China has created a new TPP alliance with the other 11 Pacific Rim nations without the US, and recent tariff actions have given rise to retaliatory measures and worries about a global trade war. The willingness of politicians and nationalist economists to rely on the strength of the US economy will likely be pushed to new extremes this year, as it is looking more likely that US consumers will be shut out, on at least some level, from the broader global growth we are already seeing. The Eurozone has had their strongest year of growth ever in 2017, at 2.5%, and China’s lofty ambitions to connect the world in trade has profound implications for global supply chains and international relations.

China, the E.U., and Tariffs all should have their own blog posts and thus do not belong in this one. Suffice it to say, however, that recent events have made it more challenging for companies to grow while being based in the US, and is starting to reflect in their stock prices.

Given all this, how should retail investors proceed with investing? Enter Fundamental Analysis.

My investing strategy is simple, at least compared to other strategies. I look at stocks based on company performance and fundamentals, with some attention paid to their industry and outlook. This is a strategy first coined by Benjamin Graham in the early 1900’s, called Value Investing, which stresses focus on company financials and performance, without much mind to what other investors are thinking or doing. This strategy is the opposite of Technical Analysis, which stresses analysis of stock price charts, discerning what is overbought or oversold, finding levels of ‘support’ or ‘resistance’ in a stock price (a range in which it stays based on buying and selling), and other terms reflective of what the masses think of a stock.

I prefer Fundamental Analysis to Technical Analysis because, though it may not be as glamorous or fun, it plays better to my Accounting background, and it holds up far better in financial down markets. The market outlook I explained earlier in this post leads me to believe that 2018 will be a buyer’s market, or a market in which the stock picker will have his choice of companies in which to put his money, and in which the seller of said company sees the down times coming and will want to get out while he is ahead.

Above all else, Fundamental Analysis is synonymous with a Buy-and-Hold approach, finding a good time to invest in a company for the long term, and reaping the rewards of the cash flows that come from it.

What is the point of this investing philosophy? I believe that to truly have a portfolio of companies that withstands the test of time, one needs to put in some due diligence and research those companies, understand their cash flow and how they operate, and not be distracted by what is going on around them.

My first step in researching a company I want to invest in is the most important step. I go to the SEC database and look at the company’s Financial Statements. There are a few Statements that show the company’s financial health. First, the Balance Sheet shows the value of its Assets (profit making items), its Liabilities (profit taking items), and its Equity (what’s left over). Recall from a previous blog post the accounting equation:

Assets = Liabilities + Equity

Meaning, if a company wants to make money, they need to have less Liabilities than Assets.

The second Financial Statement worth looking at is the company’s Income Statement, or Statement of Operations. This is the statement that tells you how well the company did at making money for that period of time. It starts at the top, with Revenue (gross sales), and subtracts expenses until it arrives at Net Income at the bottom. It is not uncommon for new, smaller companies to have negative Net Income but positive Revenue, as some higher expenses (such as marketing and interest) mean they are trying to grow into profitability more aggressively. However, I tend to like bigger, historically profitable companies better. At the end of each period of time, Net Income gets ‘closed’ from the Income Statement and rolled into the Equity section of the Balance Sheet.

The third Financial Statement to look at is the Statement of Cash Flows. This is the statement that shows the breakout of how the company moves cash around, and separates the non-cash items in other statements, such as depreciation and stock-based compensation. At the bottom of this statement, there will be a line showing the cash balance at the beginning of the period, a line for the cash balance at the end of the period, and a line showing how much cash was made or lost. At the end of each period, the cash balance will be rolled into the Assets section of the Balance Sheet.

Financial Statements for all public companies are posted for public inspection every quarter and can be found here: https://www.sec.gov/edgar/searchedgar/companysearch.html. All you have to do is type in the company’s name or ticker symbol and their filings will automatically populate, for your viewing pleasure.

See also: https://millennialeconomist.com/2018/01/20/pulling-money-out-of-thin-air-some-due-diligence-on-amd/

My second step in analyzing a company consists of running a few general ratios to determine how cheap or expensive the company’s stock is. Most important here is the Price to Earnings ratio, which shows how many times a stock is trading above its bottom line. This is where I determine which companies stand to lose the most in a downturn, and which are more defensive buys. Traditional Value Investing says to keep this ratio between 5 and 25, with companies below 5 being too cheap, and likely without the prospect to advance in future years, and companies above 25 too expensive, likely trading on irrational behavior and thus more susceptible to rapid price decrease on bad news. The ratio is derived from dividing a company’s Stock Price by its Earnings per Share (Net Income divided by amount of shares). For instance, in 2017, AT&T had a stock price of about $37 and per-share Net Income of $4.77, making a P/E ratio of $37/$4.76, or 7.77. This is on the lower end, which is good news, given the size and impact of AT&T as a company. However, it likely reflects the poor likelihood of their merger with Time Warner passing US regulatory overview and the impending lawsuit.

On the flip side, a tech company like Take-Two Interactive (the company behind the 2K and Grand Theft Auto video games) had a stock price of about $110 with per-share income of ~$0.98, making a P/E ratio of $110/$0.98, or 112.24! This company is a lead player in an industry with tremendous growth, as the rapidly changing world of video games gives opportunity to make some serious money, as long as they can continue pumping out fun, playable games. But a ratio that high? I’m not interested in that big of a gamble.

Another ratio to consider is the price to Book ratio. This one is not as important, but it compares the company’s stock price to the value of its Balance Sheet, or Book Value, to determine if the stock is trading lower than the company is physically worth. Recall that the Accounting Equation has Assets on one side, an Liabilities + Equity on the other side, meaning either side will constitute Book Value. I try to keep this ratio around 2. Much higher than 2 would mean the company does not have the capacity to make enough money to support their stock price, and much lower than 2 means the company is worth significantly less in the market than on paper, and may either be a fantastic steal or a money-losing proposition.

For an example of this ratio, we can again look at AT&T, who’s share price of $37 divided by its per-share book value of $13.97 (Assets divided by Shares Outstanding) gives a P/B ratio of 2.64. Our other company, Take-Two, has a stock price of $110 and a book value of $32, giving it a P/B ratio of 3.44. While both companies are trading above our median 2, This tells us that AT&T may not have much more room to grow in price without growing their company’s fundamentals, while Take-Two is priced entirely too expensively relative to their capacity to make money, and thus is far more likely to respond negatively to news rather than positively.

The Third step in my Fundamental Analysis is deceptively simple; I look for stocks that pay dividends. Dividends are part of a company’s profits that are distributed directly to their shareholders after the closing of every period. Companies pay dividends for a variety of different reasons. It could be that the company wants to reward its shareholders for being faithful to it and holding the stock, or it could be that the company has gotten so big and successful that it no longer has use for all its cash. A company that pays a dividend is generally seen as a ‘safer’ play, or a company that has more value to it. Newer or smaller companies, on the other hand, will reinvest all of their profits, or pay no dividend, in order to grow faster, at least theoretically. AT&T, being a historically large and profitable company, pays an annual dividend of $2 on its stock worth $37 per share, which means it has a yield of just about 5.5%. Take-Two, being the opposite kind of company, a fast-growing tech company in a highly growing industry, pays no dividend and retains all its earnings.

Other steps in my version of Fundamental Analysis, such as looking at industry growth rates and the price of competitors’ shares, are optional and not necessary. These metrics are generally all I use in order to determine which stocks are buys and which are not.

So, now that you’ve read how I choose my stocks, are you wondering how this strategy works in action? My last big stock purchase was with Cisco Systems (CSCO) and I employed this strategy to find an attractive buy point. Cisco is a giant tech conglomerate, with over 200 independent businesses under its corporate umbrella. They produce switches, keyboards, and other tech hardware you commonly see in offices and computer labs around the world. I had wanted to own this company for a while because of their size and yield, but thought they were always a little too expensive. Then, on August 17, 2017, it dropped to a share price of $31.33. On that day, its dividend was a very attractive 3.71%, its earnings per share was $1.92, giving it a P/E of 16.32, and its book value was $25.71 per share, giving it a P/B ratio of 1.22. With ratios like these, and such a high yield, I felt compelled to buy at that price. Maybe the company was getting some bad press due to the tax reform? Or maybe the company wasn’t responding well to the growth prospects of Tech as a sector due to their business lines being focused on hardware, and not software? Either way, I did not think the company was justifiably valued at such a low price, yet the market was telling me that they were. So, I simply had to buy it. Sure enough, just a few short months later, in March 2018, Cisco’s share price rose to a whopping $45! This translates into a 44% gain in a few months.

In conclusion, no matter what the challenges the stock market brings in the coming months, there are ways to make your picks wisely and profit. Fundamental Analysis is my investing philosophy of choice, focused on specific company performance and determining if the stock price is justified in comparison to the company’s financial fundamentals. As we move into more volatile, turbulent times, a level head and a clear investing strategy will see you through with a solid portfolio of companies.

Categories: Finance

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